How Interest Rates Work and How They Affect You

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What is an interest rate?

To understand how interest rates work and how they affect you personally – there are a few things to know about them. First things first: An interest rate is the percentage of principal charged by the lender for the use of its money. The principal is the amount of money loaned to you.

Interest rates affect the cost of loans. As a result, they can speed up or slow down your ability to repay the loan. The Bank of Canada manages interest rates to achieve ideal economic growth. Consider interest rates as either the cost of borrowing money or the reward for saving it. Rates get calculated as a percentage of the amount borrowed or saved. Depending on how you are using interest rates, a higher one would benefit a high-interest savings account and a lower one for a personal loan or credit card.

How do interest rates work?

The Bank of Canada exists to regulate and monitor the Canadian financial system and help keep the rate of inflation stable and low to grow. It acts as a research institution, surveilling how many economic factors affect the value of Canadian money, and sets the policy interest rate.

What is a policy rate? A policy interest rate, also known as the overnight rate, is the interest rate charged on the loans between the major banking institutions.

When referring to a loan, the bank applies the interest rate to the total unpaid portion of your loan or credit card balance, and you must pay at least the interest in each compounding period. If not, your outstanding debt will increase even though you are making payments. In other words, if you don’t pay off at least the interest with each payment that comes due, there will be interest charged on top of that unpaid interest next time around.

How do interest rates affect me?

When the Bank of Canada lowers or raises the overnight rate, it factors into the way commercial banks apply interest on credit they’ve extended (e.g., credit card, mortgage, or line of credit) and what they agree to pay as interest on their savings products (for instance, a high-interest savings account).

A lowering of the policy interest rate typically means the banks will change their interest terms—for both credit they’re lending out and interest they pay on savings and investments.

In general, when the Bank of Canada changes the policy interest rate, it sets off a chain reaction that affects lending rates from every bank. Each bank determines its own “prime lending rate,” which is primarily influenced by the Bank of Canada’s policy interest rate.

Each commercial bank uses its prime rate as the building block for many different lending services. Like most consumers, you probably think of the prime rate as significant to mortgages specifically. They are indeed important to mortgages, but to many other loans as well. It is essential to be aware of how interest rates affect your decisions, both personally and professionally. 

How do I keep my interest rates low?

There is no simple answer here, it depends on what kind of loan you are taking. Lenders typically tie the interest rates they charge to the risk of being paid back or recovering their money. This is why your credit score is so important. Your credit score is an easy way for lenders to assess how good you are at paying back loans. Typically, the worse your credit score is, the higher the interest rate you will be charged. This applies to both secured (something provided as collateral) and unsecured loans. 

The best thing you can do to bring down the cost of high dollar item loans, such as a car loan or mortgage, is to reduce the number of loans you have outstanding. You can do this by lowering the average unpaid balance on any credit cards you have, and work on increasing your credit score. Using a service like Lendy doesn’t impact your credit score, but can give you the money you need to pay off those credit cards and start rebuilding your creditworthiness.

Lendy is a company dedicated to social good. We aim to help individuals and families across Ontario and Canada unlock the value of their possessions, and improve their financial stability. Our collateral loans are tailored to put money in the bank when you need it. If you’re ready to get back in control of your debt, Let’s Get Lendy

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